Great question here from David, a newer member of the VTS community:
"I noticed the VIX futures are almost in contango. Does that mean I should short volatility now?"
Thanks for the question. This is a topic I've discussed quite a bit in the past so longer term members will already know the answer, but it's always worth repeating because far too many people on Twitter still repeat it. I can't even tell you how many times I've heard people say that shorting volatility when VIX futures cross into contango is an actionable signal. In my opinion it certainly is not.
I wrote an extended article on Seeking Alpha discussing this topic with examples, it's here if you want to give it a read later.
The basic reason that the 0% line for contango is such a bad signal is because it includes far too many low quality market environments. The front two month VIX futures have spent roughly 83% of the time in contango since the VIX futures launched in 2004. That's far too high a percentage of trading days to be shorting volatility.
As of market close yesterday (Jan. 8, 2019) the front two month VIX futures M1:M2 closed at 0% contango.
You can see in the chart, the current level of 0% is the 16.60 percentile rank, meaning 83.40% of trading days since 2004 had higher levels of contango than we see now. The 50% line is all the way to 6.35% contango
We can also look further out the VIX curve to the 4th-7th month futures. These are the futures that the less popular but in my opinion highly underrated products ZIV and VXZ are based on.
Further out at the 4th - 7th month futures, they are still in backwardation of -1.24% which is only the 11.10 percentile level. Nearly 90% of trading days going back to 2004 had higher levels of M4-M7 contango than we see now.
If a trader was in the habit of shorting volatility 80-90% of the time, it would lead to very poor performance and gut wrenchingly large drawdowns. In my opinion, that 0% contango signal is a total non starter.
I showed a longer term example in my Seeking Alpha article but we can also see this quite clearly as well with a recent example.
Here's what the performance in 2018 would have looked like if a trader was short volatility only during times of M1:M2 VIX futures contango, and moved to cash during backwardation.
And remember, VIX futures went into backwardation a few days before the February 5th Volmageddon spike so the trader would have avoided the disaster on that day. Even so, with no losses at all during that crazy volatility spike, that 0% contango strategy was still down over -40%.
The most challenging aspect of trading volatility products is not avoiding the largest losing days. That's typically fairly easy with a few basic volatility metric filters. Now granted those terrible days could technically come out of nowhere and happen at any time, but historically speaking there's usually some warning signs ahead of time that any basic filters will pick up on.
The real challenge is avoiding all the whipsaw up and down action that is so common within the volatility space. And if a trader is in the habit of taking short volatility positions 80-90% of the time, they are going to experience most of them. Not only will that be financially costly by bleeding capital, but it will also expend a large amount of their emotional capital as well just riding that roller coaster.
So answering the original question:
1) Successful volatility trading requires far more than just one or two metrics. So while the M1:M2 VIX futures level is important, it's only one of many metrics that I personally use to filter trade decisions. One small cog in a very large wheel.
2) Even just looking at that metric on it's own, the 0% line still includes far too many low quality environments because in the long-run, over 83% of the time we do see contango. That's not nearly a strict enough filter to avoid the whipsaw action.
So I'm definitely encouraged to see the volatility complex normalizing, but I wouldn't say we're there just yet. The damage that was done during the 4th quarter of 2018 will take a bit of time to work through. Everything is moving in the right direction, but there's a few more levels I'd like to see crossed before I sound the all clear. I for one will remain patient.
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